Had I been a lecturer at a university in the past, and if I had, at the time, the opportunity to grade student Ben Bernanke, we would have today a different Fed chairman. I would have had to let him fail his final exams. I would have told him that he might be better off to learn the trade of a printer than that of an economist. In a printing shop he could have printed everything, from porno to books on Christian fundamentalism, but at least the world would have been spared from having him at the US Federal Reserve. At the Fed he will inevitably follow the footsteps of his predecessor, Mr. Greenspan, and continue to print money. Under him the US dollar will continue to lose its purchasing power against goods and assets at an increasing rate, as it has since the formation of the US Federal Reserve in 1913.
It is true that the Fed has been increasing short term interest rates from 1% to 4.75%, since June 2004, but only in baby steps, and at the same time, without really tightening (see figure 1).
Figure 1: US Bond Yield and Nominal GDP Growth, 1962 - 2006
Source: Ed Yardeni, www.yardeni.com
As can be seen from figure 1, bond yields were below nominal GDP growth between 1962 and 1979. This was also the period during which inflation accelerated and gold prices rose from $ 35 in the sixties to $ 850 in January 1980. At the end of the 1970s, Mr. Volcker, the only solid central banker the US has had in the last 50 years, increased interest rates massively and squeezed the economy (see figure 1). Thereafter, until the late 1990s, Treasury bond yields were above nominal GDP growth, which brought about a period of disinflation. But now, and for the last few years, US bond yields are not only again below nominal GDP growth but also below the rate of inflation. This, is obviously inflationary. But the market participants are not totally stupid. Whereas Mr. Bernanke can print as much money as he likes and, therefore, support the inflated US stock and housing market, he cannot prevent US assets from declining against gold (see figure 2). As can be seen from figure 2, over the last one and five years, gold has significantly out-performed US equities.
Figure 2: Gold and US Stocks annualized historical returns
Source: Ned Schmidt, The Value View Gold Report
In fact, since the money printer Mr. Bernanke was appointed as new Fed chairman, gold has rallied by almost 50%. Moreover, whereas the S&P and the NASDAQ are up since the beginning of the year by 5% in US dollars, gold has rallied since January 1, 2006 by more than 20% (I may add that in the relatively healthy Singapore dollar and Swiss Franc, the S&P 500 and the NASDAQ are flat so far for this year). So, we can see that while Mr. Bernanke can indeed print as much money as he likes, US dollar assets will simply continue to depreciate against gold and to a lesser extend against foreign currencies. I need to add that it is likely that one of these days all asset markets including gold and silver will experience a substantial correction. However, I expect on any correction Asian central banks - especially the Bank of China - to increase their gold reserves (see figure 3).
Figure 3: Gold as a Percent of Chinese Official Reserves, 1990 - 2006
Source: The Bank Credit Analyst
Please note that, as a percent of total Chinese official reserves, gold holdings did not decline because the Bank of China sold gold but because its dollar reserves rose so sharply in the last ten years. In fact, all Asian central banks hardly own any gold (see figure 4)
Figure 4: Asian Central banks holding of gold as percent of reserves
Source: The Bank Credit Analyst
So, at some point, even Asian central bankers, all of whom do not seem to be endowed with any great foresight, will realize that to invest in US bonds and T bills is not the smartest way to manage their reserves. And when this day finally arrives - I suppose when gold will be above USD 1,000 - additional buying could propel gold prices sharply higher!
There are some other points to consider. In my opinion, it will in future, never be possible for Mr. Bernanke to do a "à la Volcker 1979-1980 tightening" (see figure 1), and this, even if conditions were calling for such action! Why? Because, when Paul Volcker implemented really tight monetary policies, debt as a percent of GDP was only 120% and asset prices such as homes and stocks were depressed. But, today, with total credit market debt at over 320% of GDP and with asset prices being badly inflated, tight monetary policies "à la Volcker" would have a lethal impact on US consumers, which are the only driver of the economy thanks to the extraction of money from rising home prices. In fact, given the debt level in the US, I believe, that Mr. Bernanke has really no other option but to print more and more money if he wants to avoid a deflationary recession/depression.
Also, while the Fed has increased short term rates since June 2004 in baby steps, money is simply not tight. In the fourth quarter of 2005, financial and non-financial credit grew at a rate 39% above the rate in the second quarter of 2004, when the Fed began to increase short term interest rates! Moreover, whereas the Fed Fund rate is now at 4.75% compared to 1% then, inflation - measured by true price increases and not by the government's Ministry of Truth (BLS) - is running at least at between 5% and 6%, which means that it still pays to borrow money, as real rates remain negative.
I may also add that it does not require an economist with lots of degrees to see that if money were "tight", asset prices would not be soaring and speculation would not be rampant in all asset markets (see figure 5). In fact, what surprises me is how many investors feel that the gold market is way ahead of itself but are very confident to invest in US equities. But, as we can see from figure 5, speculation in equities is at least as widespread as in the commodity markets and, therefore, when asset markets will finally correct, which I expect to happen shortly, all asset markets could sell-off at the same time - the same way they also all rose in concert since October 2002. Needless to say that such a correction could lead to a temporary rebound in bond prices.
Figure 5: Average Daily Volume of Bulletin Board, 1995 -2006
Source: S&P and www.drkwresearch.com
To summarize, the higher the S&P 500 goes the more the US dollar will lose its value against gold and foreign currencies. In our opinion, the underperformance of US assets against foreign assets and precious metals, which began in 2002, will continue for as far as the eye can see.